Rate of Return is all that matters

In an interview with the Financial Times, Raghuram Rajan, governor of the Reserve Bank of India, warns governments not to rely too much on fiscal stimulus through cutting taxes or increasing public spending. Before taking such steps, they should first consider the likely returns. While any cost is acceptable to ensure potable water to people, it is not worth spending on infrastructure like roads or bridges if the expected rate of return from such projects is very low

“It is difficult to make a man understand something if his salary depends onnot understanding it” — Upton Sinclair

We have all known for a while now not only that world’s main central bankers have simply been lying through their teeth; but that it is well nigh impossible to eke out the truth from them whatever the changes in data and ground realities that may occur.

Raghuram Rajan

If anything, every setback to their rose-tinted projections of what would result from their morally bankrupt policies has simply been used as an excuse to double down on the facile assumption that things would have been a lot worse if they had not embarked on their facile policies in the first place (see “Double or Quits” dated October 6, 2009).

It was also easily predictable that Keynesian policies would persist in the face of such (predictable economic) failures because of course the starting point of all advanced economies since 2009 was their political failure – not having any leaders worth their salt, these economies were always going to grab the most convenient piece of market flotsam they could as long as it did not threaten to bring out the multitudes with their pitchforks.

So it falls upon outsiders such as Raghuram Rajan, governor of the Reserve Bank of India, to call it like he sees it – you see, his job doesn’t depend on not understanding the facile falsehoods peddled by the neo-Keynesians. In an interview with the Financial Times, the former professor and IMF chief economist explained a central tenet of spending:

“Mr Rajan said he was a supporter of stimulus policies to ‘balance things out’ over short periods when households or companies were proving excessively cautious with their spending. But eight years after the financial crisis, we “have to ask ourselves is that the real problem?”

Rajan warned governments not to rely too much on fiscal stimulus through cutting taxes or increasing public spending. “If your debt to GDP is over 100%, [and you] do more fiscal stimulus, you’d better have a pretty high rate of return in mind, otherwise your younger and middle-aged generations are thinking ‘This thing is not going to return enough, but I’m going to have to pay for it.’”

Even spending money on infrastructure projects, the recommendation of the International Monetary Fund where Rajan used to be chief economist, came in for criticism for being vague in its analysis of the likely returns.

For infrastructure, the big questions are who plans it, who funds it, what does it do and what are the likely returns, Rajan said, adding that these questions take time to get right. “There are lots of projects buried in drawers — shovel-ready projects — but these are projects that you think really were not worth funding unless somebody else was coming to put up the money”.

There are multiple points of note here, and since there is no danger any actual Keynesians are reading at this point, let me explain as follows:

Firstly government spending should not be determined by the borrowing rate but by the expected rate of return (what is referred to as IRR or Internal Rate of Return in financial circles)

Secondly when governments are seen to be spending money on low IRR projects, the populace quickly becomes wiser to the quantity of obligations being stored for their own future (generations) to repay

The most likely projects to be executed under such circumstances are the worst ones – wasteful spending that benefits very few (for example construction firms) and costs everyone else tons of money (taxpayers)

Bridges to nowhere

I believe what Rajan was referring to is known in economic circles widely as “bridges to nowhere”, a modern variation of the Bastiat Broken Glass explanation with the specific example of Japan.

Confronting a massive collapse in demand for residential and commercial properties at the end of the eighties and early nineties, successive Japanese governments identified the collapse in the construction sector (and hence jobs, GDP) as a core national problem. They used it to green light various grandiose projects that had previously been held in abeyance due to poor economics, to help the construction sector.

Curiously, despite building many new airports (that attracted few passengers), expressways and bridges (that had far too few cars plying on them), Japanese construction companies remained moribund even as consumer spending collapsed further and deflation in asset prices worsened for the entire time. In essence, Japan’s government-directed spending spree in the nineties ended up spreading the woes from the construction sector into all sectors of the economy, from tourism to beer sales.

Having been wilfully blind to the ineffective nature of the low/zero interest policies pursued by Japan off and on for the past 25 years, Keynesians now wish for G7 governments to enter the second phase of Japan’s decline namely to copy wasteful spending on “infrastructure”.

Perhaps a clarification is in order here though – I am not against all types of infrastructure spending, but would look at the expected rate of return. For example, if I was in government somewhere in Michigan (and thankfully I am decidedly not), pretty much any cost would be acceptable to ensure that residents of Flint got potable water supplies immediately. Water is life, and you simply cannot have a city in modern, continental United States being unable to supply quality water to its residents. That is simply not acceptable.

The math though becomes a lot fuzzier once you start looking at roads and bridges. Here, you’d need the following:

What is the “cost” of the bad road or bridge in terms of traffic delays

What is the cost and time involved to secure an acceptable upgrade

Thus for example:

Average per capita GDP in a region containing 100,000 people is $50,000 (so GDP of $5bn)

About 10,000 people are adversely affected by traffic delays of over 1 hour in either direction on the region’s main arterial road

It would take 1 year and $25 million to fix the main road

The benefit of a 2-hour improvement would be roughly direct i.e. assume here that time not spent on the road is broadly spent at cafes, restaurants instead of sleeping in

So the potential benefit to GDP here = (10,000*[2/12]*$50,000) = $83 million. On this basis, the spending of $25 million seems easily justifiable as the region’s GDP increases by a multiple of the spend; and assuming taxes follow such an increase, the region recoups its investment within a year.

If on the other hand, the road costs $250 million to repair instead of $25 million, you have a problem. At the current rate of tax inflows, it would take over 8 years for the region to recoup its spend; therefore at this stage, borrowing rates become important – even at 2%, this would add $40 million to the cost of the road repairs (or over a year of incremental tax revenues).

For numbers like that, even negative interest rates don’t help – the math does not work even if the project cost is reduced by a few million because of negative interest costs. A bad project simply becomes less bad but does not become bad.

Of course, economic calculations are not always as easy; add to that the complexity of “necessary” spending such as for safe water that all governments have to commit at all times.

So what about austerity?

What then is austerity in the above context? Simply put, most G7 governments entered the global financial crisis in 2009 with far too much debt that had been tacked on due to low-return, zero-return or even negative-return projects. Once the crisis hit and Debt/GDP ratios were far in excess of 100%, bond investors became cautious about lending to governments that could potentially enter a downward spiral such as what Greece was confronting at the time.

This prompted a number of governments including Germany and the UK to promulgate ‘austerity’ as a measure to boost market confidence. In the case of Germany, worries of the Greek crisis spreading to other countries prompted a fair bit of arm-twisting against the likes of Ireland and Portugal (both of which subsequently benefited from this austerity and re-emerged as viable borrowers in the bond markets in their own right). With hundreds of billions in sovereign bonds now trading at negative interest rates, the question then becomes – does austerity have any merit any more?

It is in this context that Rajan’s statements and admonishment above must be considered by G7. Whilst it may well be tempting to think that pretty much any project could be funded on the back of low or negative interest rates (as Keynesians are now suggesting), the problem is that money spent on bad projects cannot be recouped easily; and debt always needs to be repaid.

When the population of a country thinks that too much debt has been piled up for uneconomic projects, they would simply cut their spending/increase their savings to reflect expectations for higher taxes and other costs. This is why G7 governments need to pay attention to the basic economic principle – if something does not have a good IRR, don’t bother doing it – whatever the borrowing cost.